Trade-FDI-Technology Linkages in East Asiaceac.jp/j/pdf/neat/04wg_7.pdf · capabilities, they can attempt to progress from original equipment manufacturing (OEM) to original design

(Finalized, 21 July 2006)

Trade-FDI-Technology Linkages in East Asia

Drafted by Willem Thorbecke and Masaru Yoshitomi*

Prepared for the NEAT Working Group on “Trade- FDI-Technology

Linkages in East Asia” Sponsored by the Research Institute of Economy, Trade and Industry (RIETI) Tokyo, Japan,**

21 July 2006

Index of Contents

I. Introduction II. Global Triangular Trading Patterns in East Asia

A. Determinants of FDI Flows B. Intermediate Goods Trade in East Asia C. China’s Role in the Global Triangular Trading Patterns

III. East Asia Countries: Comrades or Competitors? IV. Exchange Rates and Production Networks in East Asia V. Policy Implications

A. How to Promote Production Networks, FDI Flows, and Technology Transfer 1. How to Lower Service Link Costs 2. How to Facilitate Technology Transfer Leveraged by Networks 3. How to Enlarge the Scope of FTAs 4. How to Enhance the Quality of Bilateral Investment Treaties

B. The Appropriate Policy Mix for the Region VI. Conclusion

_____________________________________________________________________

* Willem Thorbecke is a Senior Fellow at RIETI. Masaru Yoshitomi is President and Chief Research Officer at RIETI. We thank Mizanur Rahman for excellent research assistance. ** Extremely valuable and constructive comments by members of the NEAT Working Group at the workshop on 7 July 2006 at RIETI have been incorporated (the participants are listed at end of this draft).

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I. Introduction

East Asia is characterized by intricate production and distribution

relationships, constituting part of a global triangular trading network. Very

generally speaking, Japan, Korea, and Taiwan and MNCs located in ASEAN

produce sophisticated technology-intensive intermediate goods and capital goods

and ship them to China and ASEAN for assembly by relatively low skilled

workers. The finished products are then exported throughout the world, not only

to the U.S. and Europe but also to the rest of Asia. These production and

distribution networks have promoted economic efficiency and helped to make

East Asia as a whole (not just China) the manufacturing center of the world.

FDI flows and MNCs (multinational companies) have played an important part in

these triangular trading patterns. As Gaulier et al. (2005) discuss, FDI flows and

MNC activities have reduced costs in host countries, transferred technological and

managerial know how, increased local procurement, multiplied trade in intermediate

goods, and strengthened distribution networks.

While networks are common in other parts of the world (e.g., parts and

components exported from the U.S. for assembly in Mexico), fragmentation in East

Asia is particularly sophisticated and well-developed. It involves complicated

combinations of intra-firm trade, arms-length transactions, and outsourcing (Kimura

and Ando, 2005). One definition of these production networks has been provided by

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Borrus et al. (2000, 2):

By a lead firm’s “cross-border production network” (CPN) we mean the inter- and intra-firm relationships through which the firm organizes the entire range of its business activities: from research and development, product definition and design, to supply of inputs, manufacturing (or production of a service), distribution, and support services. We thus include the entire network of cross-border relationships between a lead firm and its own affiliates and subsidiaries, but also its subcontractors, suppliers, service providers, or other firms participating in cooperative relationships, such as standard setting or R&D [research and development] analysis.1

These networks have allowed firms to exploit comparative advantage by

slicing up long production processes and allocating the production blocks created

in this way throughout Asia. Such trade-FDI linkages have established

production-distribution networks in East Asia that can be characterized as vertical

intra-industry trade (VIIT).

This VIIT differs both from the exchange of final goods emphasized by

traditional trade theory for vertical inter-industry trade between the North and the

South (e.g., between capital goods and apparel) and for horizontal intra-industry

trade between the North and the North (e.g., between two differentiated types of

automobiles). As Fukao et al. (2002) discuss, the production processes of an

industry (e.g., the electronics industry) has been split into fragmented production

blocks that can be located in different countries and the new VIIT is essentially

based on differences in factor endowments in the fragmented production blocks

between developing, emerging, and developed economies in the region. 1 Also quoted in Yusuf et al. (2003).

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To promote these trade-FDI-technology linkages it is important to lower the

service link costs between production blocks (Kimura and Ando, 2005). This can

be done by strengthening physical and ICT infrastructure across the region,

increasing the knowledge base, enforcing high standards of corporate governance,

and providing legal remedies when firms within a network relationship violate

intellectual property rights agreements (Yusuf et al., 2003).

The rapid development of such value-added chain in the region has been

accompanied by massive volumes of exports from East Asia (particularly China)

to the rest of the world and also by growing trade imbalances. The trade

imbalances are particularly large for East Asian trade with the U.S. The East

Asian surplus with the U.S. equaled $300 billion in 2004 and $350 billion in 2005,

while the overall U.S. deficit amounted to $650 billion and $770 billion,

respectively.2

Many policy questions follow from the above considerations but only

some are mentioned in this Introduction. What practical steps can each country in

the region take to lower service link costs? What policy coordination will be

necessary among countries in the region in order to strengthen service linkages

and lower related costs? How can each economy upgrade its technological and

industrial structure in the context of the production networks developed in the

region? Do production networks in East Asia have an export bias? Do overall

imports by East Asia grow less rapidly than overall exports by the region? Does

2 More than half of this surplus was recorded as being with China. If exports were measured on a value-added basis rather than on a gross basis, however, the deficit with China would have been far less and the deficit with the rest of Asia far more.

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the accumulation of foreign reserves that has accompanied the global imbalances

reflect an inefficient allocation of domestic resources within each of the Asian

countries? Are there better ways at present to allocate resources in order to

stimulate demand than by relying on export expansion? If so, what policy mix

would be appropriate? (See our own NEAT Working Group Policy

Recommendation 2005).

This paper is organized as follows. The next Section presents an

analytical description of the global triangular trading patterns. Section III

considers whether East Asian economies are comrades or competitors. Section IV

discusses implications for exchange rates of triangular trading patterns and global

imbalances. Section V identifies the main issues (both analytical and empirical)

that need to be addressed. Section VI concludes.

II. Global Triangular Trading Patterns in East Asia

A. Determinants of FDI Flows

FDI has brought benefits to both the home and the host countries. It enabled

home countries’ firms to significantly lower costs and to use developing Asia

more and more as a production platform for less technology-intensive industrial

inputs as well as labor-intensive final goods.3 It enabled host countries’ firms to

acquire engineering and managerial skills and to facilitate technological

assimilation. These firms were able to reap the efficiency gains associated with

exporting and competing in world markets. In addition, as foreign affiliates 3 ASEAN countries were not merely assembly platforms for labor-intensive goods. As discussed below, MNCs in ASEAN also produced and exported sophisticated intermediate goods.

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increased their tenure in the host countries, they procured more and more

intermediate inputs from host country firms (see Kiyota, Matsuura, Urata, and

Wei, 2006).

Starting in the 1990s, China also became an important recipient of FDI. After

the Asia Financial Crisis of 1997-98, new flows to Southeast Asia slowed.

Meanwhile, China’s accession to the WTO in 2001 increased investor confidence

and resulted in a surge of investment. The lion’s share of FDI to developing East

Asia now goes to China (see Figures 1A and 1B).

There are several ways in which the development of FDI-trade linkages have

been associated with technological upgrading in host countries (see Yusuf et al.,

2005). Recently, for instance, lead brand name firms in Asia have started

requiring suppliers to become involved in the engineering and design aspects of

the production process. As suppliers in host countries enhance their R&D

capabilities, they can attempt to progress from original equipment manufacturing

(OEM) to original design manufacturing (ODM) and finally to original brand

manufacturing (OBM), though the last step is difficult to achieve by local firms in

host countries4

Because of the benefits arising from foreign direct investment it is important

to know the factors that affect FDI flows. Instead of exploiting external markets

directly by exporting, why do firms choose to undertake FDI? When firms are

deciding on the optimal degree of fragmentation they need to weigh benefits and

costs along several dimensions (Kimura and Ando, 2005). One such dimension is

4 This process of upgrading technology in host countries is often associated with local procurement by MNCs and the resultant development of supporting industries.

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location. Another is ownership. A third is internalization. Locational

considerations and advantages include wage levels, factor endowments,

technology transferability, physical and human infrastructure, and market-

supportive institutions and political regimes. Ownership advantage is based upon

technological and managerial superiority of home country firms relative to host

country firms. Such superiority should be sufficient enough to overcome the

extra costs incurred due to differences in business customs, formal and informal

norms, languages, etc. Thus ownership is linked with control, and control

becomes weaker as ownership becomes more diluted. Of course firms that

outsource or subcontract may retain some control if they are involved in long-

term relations. There may also be benefits to relinquishing ownership if the

business partner has better managerial or technological ability in a particular

product. Internalization advantage refers to the net benefits obtained by FDI

firms through more captive and more integrated business activities conducted by

parent firms. The optimal degree of internalization revolves around how to

balance the costs of asymmetric information, incomplete contracts, and

ineffective dispute settlement mechanisms with the efficiency gains of complete

outsourcing and deverticalization.

An important question is whether the surge in FDI flows to China has come at

the expense of other Asian countries. On the one hand, Yusuf et al. (2003)

documented cases where FDI inflows into China have come at the expense of

Southeast Asia. These FDI flows were motivated by lower labor costs in China

than in places like Penang, Malaysia. On the other hand, Eichengreen and Tong

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(2005) reported that increases in FDI flows to China are associated with increases

in FDI flows to other Asian countries but with decreases in FDI flows to OECD

countries. The authors do not discuss why there should be a complimentary

relationship between FDI flows to China and other Asian countries. Mercereau

(2005) found that only two Asian countries, Singapore (and Myanmar), faced

decreases in inward FDI due to China’s success in attracting FDI. He argues that

Singapore might be affected because overseas Chinese living in Singapore may

have channeled funds that previously went elsewhere to China because they have

family connection or linguistic and cultural ties with the mainland. Appendix 1

provides more detail on these and other studies that investigate whether FDI flows

to China have crowded out FDI flows to other countries.

How exchange rates affect FDI flows and production networks is yet another

important issue for East Asia. Kiyota and Urata (2004) reported that exchange

rate volatility reduces FDI. They also find that an exchange rate regime that is

flexible but not highly volatile attracts the most FDI. These results make sense in

light of Kimura and Ando’s (2005) model since volatility increases uncertainty

and thus reduces the locational benefits of cross-border fragmentation. Bénassy-

Quéré, Coupet, and Meyer (2005) reported that the higher the quality of a

country’s institutions (including transparency, property rights protection,

prudential standards, and the extent of corruption), the more FDI the country is

able to attract. These findings also make sense in light of theoretical

considerations since the locational costs of shifting production across borders

decreases as a country’s institutions improve. Kamaly (2003) also found that

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exchange rate volatility reduces FDI flows and that more democratic institutions

are associated with larger flows.

B. Intermediate Goods Trade in East Asia

Matsunaga (2006) showed that increases in FDI into a country are associated

with increases in intermediate goods exports to that country.

Triangular trading patterns involve Japan, South Korea, Taiwan, and MNCs

in ASEAN exporting sophisticated intermediate goods to China and ASEAN for

processing and export of the final products all over the world. Examining the

flow of intermediate goods can shed light on the evolution of production networks

in Asia.5

Figure 2 (and Table 2) show Japan’s exports of intermediate goods to East

Asia. China received 38% of Japan’s exports for processing. Large quantities

also flowed to ASEAN countries and the East Asian NIEs (South Korea and

Taiwan). Figure 3 shows the level of technological intensity of Japanese exports

to East Asia.6 Not surprisingly, over 75% of these exports are either high-tech or

5 We differentiate between intermediate goods exports and parts and components exportsbut we consider both. The difference between the two categories is that intermediate goods include parts and components and semi-finished goods. We focus on intermediate goods for two reasons: 1) data for these (obtained from the CEPII-CHELEM database) are available until 2004 while data for parts and components (from the RIETI-TID database) are only available until 2003, and 2) the results are very similar using intermediate goods data or parts and components data. The data are described in detail in Appendix 2 and the parts and components data are presented in Appendix 3.

6Technological intensity is calculated by the Centre D’Etudes Prospectives et D’Information Internationale (CEPII) based on the type of goods exported measured at the HS 6 digit level. For instance, 252 products at the HS 6 digit level are classified as high-tech. See Gaulier et al. (2005).

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medium high-tech goods. In addition, almost none of these exports are low-tech

goods.

Figure 4 (and Table 3) show the NIEs’ exports of intermediate goods to East

Asia. China receives half of the NIEs’ exports of intermediate goods to the region.

Figure 5 shows that 46% of the NIEs’ exports to the region are high-tech goods

and 70% are either high-tech or medium high-tech goods. 10% of these exports

are low-tech goods.

Figure 6 (and Table 4) indicate the back and forth nature of intermediate

goods trade in East Asia (see Kimura and Ando, 2005). Not only do ASEAN

countries receive large quantities of intermediate goods from East Asia, they also

export large quantities back. To see that ASEAN countries play an important role

in exporting intermediate goods note that in 2004 ASEAN’s exports of

intermediate goods to the rest of the region equaled about 60% of Japan’s

intermediate goods exports to China. Figure 7 shows that 23% of the goods

exported by ASEAN to East Asia as a whole are low-tech goods. On the other

hand, Figure 8 shows that 75% of the goods exported by ASEAN to China are

either high-tech or medium high tech goods. These data highlight the importance

of MNCs operating in ASEAN countries.

Figure 9 (and Table 5) show China’s exports of intermediate goods to East

Asia. They indicate that China exported over $20 billion of intermediate goods to

East Asia in 2004. By contrast Japan’s intermediate goods exports to China that

year equaled $70 billion. While Japan was the largest single recipient of China’s

exports for processing, 60% of these exports went to other countries in the region.

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Figure 10 shows that over 30% of the goods that China exports to East Asia are

low-tech goods.

Figure 11 (and Table 6) report results for East Asia aggregated together. They

indicate that intermediate goods exports from East Asia to China exploded after

2001. Exports from the region to ASEAN 4 and the NIEs nevertheless remained

strong. As would be expected, intermediate goods exports from East Asia to

Japan were the smallest. Even so, the rest of Asia exported $30 billion of

intermediate goods to Japan in 2004.

Given the multiplication of intermediate goods exports from East Asia to

China, the next section investigates Chinese processing trade in more detail.

C. China’s Role in the Global Triangular Trading Patterns

Table 7 shows China’s role in this triangular trading structure. The data are

taken from China’s Customs Statistics, which distinguish between imports and

exports linked to processing trade and ordinary imports and exports. Imports for

processing are goods that are brought into China for processing and subsequent

re-export. Processed exports, as classified by Chinese customs authorities, are

goods that are produced in this way. Imports for processing are primarily

intermediate goods but also include some primary goods and some final goods.7

They are imported duty free and neither these imports nor the finished goods

7 In 2003 36% of imports for processing were semi-finished goods, 42% were

parts and components, 3% were primary goods, 5% were consumption goods, and 13% were capital goods. We are indebted to Deniz Unal-Kesenci for this information.

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produced using these imports normally enter China’s domestic market. By

contrast, ordinary imports are goods that are intended for the domestic market and

ordinary exports are goods that are produced using local inputs.

Table 7 shows that in 2005 42% of China’s imports were for processing. Of

this 42%, seven-tenths came from other East Asian countries. By contrast, less

than one-twentieth each came from the U.S. and from the EU. This indicates that

the U.S. and the E.U. do not produce many intermediate goods demanded by

China for processing. It is worth noting that China imports more goods for

processing from ASEAN countries than from the U.S. and Europe combined. As

stated above in Section II-B on intermediate goods trade in East Asia, this partly

reflects the influence of MNCs located in ASEAN that export sophisticated

technology-intensive parts and components to China.

Table 7 also shows that in 2005 55% of China’s exports were processed

exports. Of this 55% one quarter went to the U.S., another one quarter went to

East Asia (excluding Hong Kong), one-fifth went to Hong Kong (largely as

entrepôt trade), and one fifth went to Europe. It is worth noting that China’s

processed exports go all over the world, not only to the U.S. and the E.U. but also

to the rest of Asia. In fact, the share of U.S. imports of China’s processed exports

(including through Hong Kong) corresponds more or less to the share of U.S.

GDP in the world economy.

Reflecting the triangular trading structure where the U.S. and Europe largely

do not export many intermediate goods to China but China exports processed

goods to the U.S. and Europe corresponding to their respective GDP share in the

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world economy, China runs large trade surpluses with the U.S. and Europe.

However, China runs trade deficits with East Asia. According to China’s official

statistics its surplus with the U.S. equaled $114 billion in 2005 ($195 billion

including Hong Kong, as explained below) and its surplus with Europe equaled

$61 billion. Its deficit with East Asia (excluding Hong Kong) equaled $140

billion.

Because the size of China’s bilateral trade surplus with the U.S. is a

politically-charged issue, it is important to measure it accurately. Kwan (2006)

discusses how to correct for the distortionary effects of entrepôt trade through

Hong Kong. He argues that in the face of entrepôt trade import data are much

more accurate than export data. When Chinese firms transship goods through

Hong Kong, the Chinese government often does not know the final destination of

the goods. Thus they record these goods as being exported to Hong Kong. On

the other hand, when the goods arrive at their ultimate destination (e.g., the U.S.)

the importing country records the goods as coming from China. Thus Kwan

advocates using import data from both countries to calculate the trade balance.

Using this approach, the U.S. deficit with China in 2005 increases from $114

billion to $195 billion.8 This implies that the lion’s share of China’s surplus with

Hong Kong in Table 7 actually represents an important part of China’s surplus

with the U.S.

It is also instructive to examine how processing trade has evolved over time.

Figure 12 (and Table 8) show that China’s imports for processing from East Asia

8 Of course, a more sophisticated analysis would have to take account of adjustments for c.i.f. – f.o.b factors and the value-added by Hong Kong middlemen. See Fung and Lau (2003).

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exploded after 2001. The Figure and Table also show that imports for processing

from the U.S. and Europe were not large. Since imports for processing from

Hong Kong were also small, this conclusion would continue to hold if U.S. and

European imports transshipped through Hong Kong were included.

Figure 13 (and Table 9) show China’s processed exports. Processed exports

to the U.S. and Europe also surged after 2001. Figure 14 then shows that China’s

surplus in processed trade with the U.S. and Europe has ballooned in recent years.

Figure 15 measures China’s value-added in processed trade. Value-added is

defined as the difference between the value of China’s processed exports and the

value of China’s imports for processing, divided by the value of China’s

processed exports. It shows that 30-35% of the value-added comes from China

since the late 1990s, as compared with about 20% in earlier years..

III. East Asia Countries: Comrades or Competitors?

At first blush one would expect a complementary relationship between

developed and developing East Asian economies, and a competitive relationship

between developing economies in the region. Figures 17-20 present a modified

version of Belassa’s revealed comparative advantage measure.9 Broadly speaking,

the Figures indicate that Japan and the NIEs have a comparative advantage in

intermediate and capital goods and that China and ASEAN in consumption goods.

Given the international slicing up of the value-added chain, Japan and the NIEs

9 The data are constructed for 71 individual products using shares of the overall trade balance rather than relative export structure as in Balassa (1965). Values for stages of production are then calculated by summing. See www.cepii.fr for a detailed description of how the data are constructed.

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http://www.cepii.fr/

should be partners with China and ASEAN while China and ASEAN should

compete with each other.

Some evidence is consistent with this scenario. Eichengreen et al. (2004)

report results from a gravity model indicating that an increase in China’s exports

to third markets tends to reduce the labor-intensive consumption goods exports of

other Asian countries. These results thus imply that there is essentially a

complementary relationship between China and developed Asia in sophisticated

intermediate and capital goods and largely a competitive relationship between

China and less developed Asian countries in labor-intensive consumer products.

Kwan (2002) also found evidence of a complementary relationship between

China and Japan and a competitive relationship between China and ASEAN

countries by using U.S. customs data and 1100 product items. He compared the

value of exports from China to the U.S. in a product category with the value of

exports from another Asian country to the U.S. in the same product category, as a

percentage of the other country’s total exports to the U.S. His work thus sheds

light on the extent to which China’s exports to the U.S. and other Asian countries’

exports to the U.S. are in similar product categories. The results, reported in

Table 12, indicate that there is not much overlap between China’s exports to the

U.S. on the one hand and those of Japan and South Korea on the other hand.10

There is considerably more overlap, however, between China’s exports to the U.S.

and those of ASEAN countries. Thus there should be much more competition

10 This overlap would be even less if one took account of the fact that in many cases much of the value-added of goods recorded as being produced in China actually came from Japan and South Korea.

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between China and ASEAN in third markets than between China and developed

Asia.

Bénassy-Quéré and Lahrèche-Révil (2003) also reported evidence of a

competitive relationship among Asian economies. Using panel data techniques

and annual data from 1984 to 2001, they reported that a 10% real appreciation in

one East Asian country (other than Japan) reduced real exports to other East

Asian countries by 8%. Thus individual East Asian economies may fear a loss of

competitiveness relative to neighboring countries.

Other evidence indicates that the relationship between East Asian countries

may be more nuanced. As discussed above, some evidence indicates that FDI

flows to China have not in most cases reduced FDI flows to other Asian countries.

The results in Table 12 indicate that there is a complementary relationship

between China and MNCs located in ASEAN that export sophisticated

technology-intensive parts and components there for processing. Ahearne et al.

(2003) report a positive relationship between China’s exports and the exports

from emerging Asian economies. They interpreted this to mean that China and

emerging Asia are comrades, not competitors. Finally, as Gaulier, Lemoine, and

Nal-Kesenci (2006) report, ASEAN has not been crowded out of world export

markets nor lost market share in dynamic products such as electronics goods.

Figure 18 and Table 17 show that while final goods exports from China have

exploded, final goods exports from ASEAN countries have nonetheless remained

solid.

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Yet another way of analyzing whether China may be benefiting and harming

other East Asian economies is through observing effects on the terms of trade.

China imports large quantities of technology-intensive goods and primary

commodities and exports large quantities of labor-intensive final goods. In the

process it has raised prices for the former goods and lowered prices for the latter

goods. This has improved the terms of trade for developed countries like Japan

and worsened the terms of trade for other developing countries specializing in

labor-intensive exports but not necessarily primary commodities. This effect is

likely to continue into the future.

IV. Exchange Rates and Production Networks in East Asia

How would exchange rate changes affect global triangular trading patterns?

Kamada and Takagawa (2005), controlling for imported inputs by including

current and future exports in regressions using quarterly data from 1990 to 2003,

found that in most cases the price elasticity of imports for East Asian countries

was not statistically significant. Ahearne et al. (2003), using a vector

autoregression and annual data from 1981 to 2001, found that income growth in

importing countries was a much more significant determinant of exports from

East Asia than exchange rate changes. Ito and Yoshida (2005), seeking to explain

East Asian exports in the context of a triangular trading model using annual data

from 1990 to 2000, found that exchange rate volatility did not help to explain East

Asian exports to the U.S.

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Thorbecke (2006a) disaggregated exports into intermediate goods, capital

goods, and consumption goods. Disaggregating by stages of production should

shed light on how exchange rate changes affect trade within Asia, given the

importance of fragmented production blocks in the region. Using panel data

techniques and data between 1982 and 2003 he found that bilateral real exchange

rates appreciations in Japan, South Korea, and Taiwan relative to other East Asian

countries caused a small drop in intermediate goods exports and a large drop in

capital goods exports to East Asian trading partners. He also reported that

exchange rate volatility, as measured by the annual coefficient of variation

calculated using quarterly data, deterred intermediate goods exports but not

capital goods exports in the region. This evidence suggests that intermediate

goods exports, which play a key role in intra-firm exchanges, are not affected that

much by the level of the exchange rate but are affected by exchange rate volatility.

On the other hand capital goods exports, which are often part of arm’s length

transactions, are affected by the level of the exchange rate but not by exchange

rate volatility. These results indicate that 1) relative exchange rate stability would

facilitate the flow of intermediate goods through regional production networks,

and 2) appreciations in developed Asia relative to developing Asia would hamper

the flow of sophisticated capital goods that are difficult to procure elsewhere.

It is also necessary to consider how an appreciation of the RMB would affect

China’s trade balance. Marquez and Schindler (2006), using data from 1997 to

2004, regressed the share of China’s exports and imports relative to rest of the

world exports and imports on the multilateral RMB exchange rate and other

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variables. They reported that a ten percent appreciation of the RMB reduces the

share of China’s exports in world exports by half a percentage point and the share

of China’s imports in world imports by a tenth of a percentage point. Thus an

appreciation of the RMB would cause a noticeable decline in China’s surplus.

Thorbecke (2006b) investigated how a bilateral appreciation of the RMB

against the dollar would affect China’s trade balance with the U.S. Using

cointegration techniques and quarterly data from 1987 to 2005 he found that the

sum of the price elasticities of exports and imports exceeded unity. These results

indicate that an appreciation of the RMB would reduce China’s surplus with the

U.S.

V. Policy Issues and Recommendations

A. Promoting Production Networks, FDI Flows, and Technology Transfer

1) How to Lower Service Link Costs

Lowering service link costs between geographically separated production

blocks can facilitate the functioning of the sliced value chain. These costs can be

lowered along two dimensions, “distance” and “controllability” (Kimura and

Ando, 2005). Our focus is on the former.

Costs along the distance dimension include transport costs,

telecommunication costs, and intra-firm coordination costs. Costs along the

controllability dimension include the costs of imperfect information, lack of

credibility, and loss of stable contracts. To lower service link costs policymakers

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should focus on strengthening physical infrastructure such as 1) the network of

highways, ports, and airports, 2) the ICT infrastructure, 3) container yards, and

also market-supportive institutional infrastructure such as 1) enforcement of the

legal system, 2) information on vendors, 3) enforcement of the stability of private

contracts, 4) corporate governance, and 5) legal remedies when firms violate

intellectual property rights agreements.

Lowering service link costs can lead to many firms locating in one area.

There are then economies of scale attached to the resulting agglomeration.

Service link costs are lowered because the large number of firms in close

proximity makes it easier for firms to procure parts and components and to handle

frequent specification changes. In addition, the many business partners and

different skills and technologies in close proximity help reduce costs associated

with uncontrollability.

Developing countries seeking to promote trade-FDI-technology linkages

through agglomeration might do well to learn from the model of Shenzhen and

the Pearl River Delta and more recently the Yangtze River Delta. It is hard to

implement the necessary policy and infrastructural changes for a whole country

but probably easier to do for a city or province.11 In these Deltas there are superb

networks of modern highways, ports, and airports. Many firms have located there,

leading to economies of scale and profitable interactions between upstream and

downstream industries. If such infrastructure has to be built across countries,

regional coordination and cooperation will become indispensable.

11 Kimura and Ando (2005).

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For instance, 80% of the international production of notebook PCs is now

produced in the Yangtze River Delta by a dozen Taiwanese Original Design

Manufacturers (ODMs). They form part of a network consisting of the makers of

OS (Microsoft) and MPU (Intel), branded makers (HP, Apple, Toshiba, etc.),

suppliers of key parts and components, and producers of basic industrial materials.

Both digital and human networks enable these producers to react efficiently in

real time to changes in consumer preferences and technology (see Yoshitomi,

2006).

2) How to Facilitate Technology Transfer Leveraged by Networks

For developing countries in the region to reap the full benefits of the trade-

FDI-technology networks, it is necessary for their economies to move up the

value chain and not remain engaged only in labor-intensive assembling activities.

Technology transfer and upgrading is an essential element of this process.

The intra-firm transfer of managerial technology from foreign affiliates to

indigenous workers can be expedited if workers in the host country are highly

educated.12 Thus human capital formation is a prerequisite for technology

transfer.

Similarly, a strong local knowledge base is essential for supplier firms to

become involved in the engineering and even design aspects of production.13 To

build the knowledge base, students need a high quality education in science and

12 Urata (2006). 13 Yusuf et al., 2003.

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math at the secondary school level and scientific training at the university level

(see Yusuf et al., 2003).

Appropriate R&D policy should take into account each country’s level of

technological innovation.14 Countries at early stages of development typically

imitate imported technology. R&D at this stage largely takes the form of learning,

doing, using, failing (LDUF). Since imported technology is expensive, a careful

selection is necessary for assimilation rather than just imitation. In this case,

domestic R&D supported by public research institutes can help indicate what

technologies are most appropriate to import.

Countries then advance from the imitation to the assimilation stage to begin

innovating and leveraging new technological capabilities. Public-private

cooperation, such as happened with Taipei, China’s industrial technology research,

can help at this stage.

Developing economies also receive technology spillovers when foreign

affiliates increase local procurement in the host countries. Local procurement

increases with the length of time the affiliate has operated in the host country.

To facilitate their long tenure it is necessary to sustain FDI-friendly environments

including consistent and coherent enforcement of laws and regulations at all

governmental levels as well as stable macroeconomic fundamentals. FTAs for

trade and FDI liberalization and facilitation are thus important.

3) How to Enlarge the Scope of FTAs

14 See Yoshitomi, Azis, and Thorbecke (1993).

22

Even if your trading partners do not liberalize, your country will reap the

gains from trade by liberalizing unilaterally. This basic message of liberalization

is often forgotten, particularly when negotiating FTAs. Global liberalization

would produce even greater gains by leading to a more efficient allocation of

resources in the international economy along the lines of comparative advantage,

as compared with the case of FTAs between a limited number of countries. FTAs

represent one step towards global free trade. There are losers in particular sectors

from liberalization, however. It is thus necessary to facilitate labor mobility and

the movement of firms from losing to gaining sectors by providing retraining and

upgrading for workers displaced through trade liberalization and by reducing

entry barriers to new firms and facilitating exit through structural reform. Sector-

specific protectionist policies should be abandoned as much as possible, while

competition policy should be strengthened.

FTAs between developing and developed economies benefit different sectors

depending on the level of development. In general, agricultural liberalization in

developing countries benefits the agricultural sector in developing economies. On

the other hand manufacturing and service liberalization benefits these sectors in

developed economies. To enhance the benefits and quality of agreements, it is

important to reduce the scope of these sensitive items in both economies and to

enlarge the coverage of countries such as implementing a FTA for ASEAN+3 as a

whole. The broader the coverage and the lower the tariffs on both external and

internal trade, the more the “noodle” effects of FTAs caused by the rules of origin

can be mitigated.

23

4) How to Enhance the Quality of Bilateral Investment Treaties15

High quality bilateral investment treaties (BITs) help attract and retain foreign

investors in the host country. They can thus contribute to trade-FDI-technology

linkages in East Asia.

Ideally, BITs should provide three substantive clauses and one procedural

component. The three substantive clauses are investment protection, investment

facilitation, and investment liberalization and the procedural component is dispute

settlement. Investment protection provides compensation in the case of

expropriation and mandates fair and equitable treatment of foreign investment to

avoid wrongful termination of government contracts. Investment facilitation

requires transparency (i.e., that all relevant laws be publicly proclaimed).

Investment liberalization emphasizes freer market access of investment (i.e., no

restrictions on ownership). Along this line, national treatment, that is, that foreign

firms should receive the same treatment as domestic firms, should be mandated.

Dispute settlement involves state parties providing a “standing” offer to arbitrate

with individuals or states in the case of a disagreement.

Minimum standard BITs provide only for investment protection and dispute

settlement while high standard BITs also include an investment liberalization

clause.

High standard BITs are required to further promote Trade-FDI-Technology

linkages, but even the minimum standards are not met by some BITs in the region

including the China-Japan BIT of 1988.

B. The Appropriate Policy Mix for the Region16

15 This Section draws on Kotera (2006). 16 We are very grateful to participants at both the 2005 and 2006 NEAT Working Group Meetings in Tokyo for their valuable and constructive comments concerning the issues discussed in this Section.

24

In recent years Asian monetary authorities have accumulated large quantities

of foreign reserves and sterilized these purchases through issuing central bank bills.

The objectives of Asian central banks in accumulating these reserves have been: 1) to

be prepared for another capital account crisis which would drain foreign reserves due

to massive reversals of short-term capital flows, and 2) to maintain competitive

exchange rates in order to sustain the export-oriented thrusts of their economies.17

While Asian economies have maintained their export dynamism, problems are

emerging. The massive quantity of central bank bills in bank balance sheets has

eroded the profitability of commercial banks and interfered with the allocation of

credit through the financial system. In addition, the real return measured in

domestic terms on the more than one trillion dollars of external reserves is likely

to be zero, far below the private and social rates of return that could be earned if

investments were channeled into the domestic economy (Summers, 2006).

It might thus be an opportune time for Asian countries to begin weaning

themselves away from foreign reserve accumulation and instead to allow their

currencies to appreciate. A free floating regime, however, would probably be

inappropriate for developing countries in the region. Given their shallow and narrow

domestic capital markets, a free float would generate excessively volatile exchange

rates and disrupt the flow of FDI and intermediate goods. Instead, greater exchange

rate flexibility in the context of a multiple currency basket-based reference rate with a

band would be preferable.18

17 Observers agree that reserves are far in excess of those needed to meet a capital account crisis (see, e.g., Summers, 2006). 18Greater flexibility would benefit China because it will begin to increasingly face de facto capital account convertibility with the free entry of foreign banks for renminbi-based financial activities

25

There are currently a variety of exchange rate systems in the region. Japan

and South Korea have essentially free floating regimes; Thailand uses a managed

float; Indonesia has a dollar peg; and China has a de facto fixed exchange rate

regime.19 Under the current system, if the trade imbalances documented above

triggered appreciations in the region, currencies in developed Asia would

appreciate relative to currencies in developing Asia. This would harm firms in

Japan, South Korea, and Taiwan by causing large drops in intermediate and

capital goods exports to the rest of Asia. In addition, this would harm firms in

developing Asia since it is difficult for them to procure vital imported inputs

elsewhere. This problem could be mitigated if countries with less flexible

exchange rate regimes adopted more flexible regimes.

In addition, countries should consider seeking higher returns on their existing

excess reserves (those above what are needed to be prepared for a capital account

crisis). Singapore has invested excess foreign reserves in stocks, bonds, and other

assets since 1981. These reserves, managed by the Government of Singapore

Investment Corporation, have earned a nominal return in Singapore dollars of

8.2% per annum on average since 1981. Other countries in the region with large

quantities of excess reserves should consider a similar strategy.

If Asian countries allowed their currencies to appreciate instead of

accumulating additional reserves, it would have a recessionary impact. This could be

due to the terms of her WTO accession commitments. In this case wider bands would enable her to maintain greater monetary policy autonomy in the face of volatile capital flows. In addition, increased flexibility would provide Chinese banks and traders with experience in managing exchange rate risk 19 China made the first step towards moving away from a fixed exchange rate system on 21 July 2005. More changes are likely to follow.

26

offset by appropriate macroeconomic and structural policies. Switching policies such

as exchange rate appreciations thus need to be combined with absorption-increasing

policies.

Absorption-increasing policies include employing fiscal and structural

policies to build both physical and human infrastructure (particularly in rural areas),

using deregulation to promote competition and productivity growth in the non-

tradable sector, and strengthening social safety nets so that consumers would have

less need for precautionary saving. These policies could promote production for

domestic markets and thus rely more on domestic markets rather than exports to

create jobs.

Combining expenditure-increasing policies with expenditure-switching

policies would thus be the appropriate policy mix for Asian countries that had

previously accumulated massive reserves. On the one hand, without exchange rate

appreciations, policies aimed simply at increasing domestic demand could produce

overheated economies. On the other hand, without policies to increase domestic

demand, exchange rate appreciations would be contractionary. By combining these

two, namely by implementing an appropriate policy mix, could Asian economies

move away from excessive reserve accumulation and simultaneously achieve external

and internal equilibria.

VI. Conclusion

27

This paper has provided an analytical description of production networks in

East Asia. These networks have enabled firms to slice up long production

processes and allocate fragmented production blocks across developing, emerging,

and developed economies in the region based on comparative advantage as

determined by relative endowments of capital, skill, and labor and by physical and

institutional infrastructure. The resulting efficiency gains have been enormous.

Two sets of policy recommendations have emerged from the discussion in

this paper. The first concerns promote production networks, FDI flows, and

technology transfer. The second concerns the appropriate policy mix for the

region.

In the first area lowering service link costs between fragmented production

blocks can facilitate the functioning of the sliced value chain. These costs can be

lowered by strengthening both the physical and the institutional infrastructure.

Developing countries can also facilitate technology transfer by investing in

education and public research institutes that indicate what technologies are most

appropriate to import. FTAs can also generate gains from trade, especially when

they are a stepping stone towards global liberalization. Finally, bilateral

investment treaties that guarantee a minimum standard under international law

can help attract and retain foreign investment in a country.

In the second area it is argued that continued reserve accumulation by Asian

central banks is becoming problematic. The accumulation of central bank bills on

bank balance sheets has eroded the profitability of commercial banks and interfered

with the allocation of credit. In addition, the real return in domestic terms on the

28

excess reserves is far below the private and social rates of return that could be earned

if investments were channeled into the domestic economy. Now might be an

opportune time for Asian countries to wean themselves away from continued foreign

reserve accumulation and instead to allow their exchange rates to appreciate. Such

exchange rate appreciations would be recessionary, however, and should be combined

with absorption-increasing policies (e.g., investing in physical and human

infrastructure).

Finally, governments in the region should consider seeking a higher return on

external reserves in excess of those needed to be prepared for a capital account crisis.

Singapore, for imstance, has invested excess foreign reserves in stocks, bonds, and

other assets and earned a nominal return in Singapore dollars of 8.2% per annum on

average since 1981. If other East Asian countries were to receive comparable returns

on their massive reserves, the gains could equal $100 billion per year (see Summers,

2006).

29

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32

Figure 1A. Inward FDI Flows to East Asia

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

1993 1995 1997 1999 2001 2003Year

Perc

ent o

f of H

ost C

ount

ry o

r R

egio

n G

DP

China

S. Korea +Taiwan

ASEAN4

Table 1A. Inward FDI Flows to East Asia (Percent of GDP) Regions 1993 1996 1999 2000 2001 2002 2003

China 4.6 4.9 3.9 3.6 3.8 3.9 3.3

ASEAN 4 2.5 2.5 2.4 0.9 0.6 1.3 0.8

S. Korea + Taiwan 0.3 0.5 1.7 1.8 1.0 0.5 0.4

Source: CEPII-CHELEM Database.

33

Figure 1B. Outward FDI Flows from Japan and the NIEs

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1992 1994 1996 1998 2000 2002 2004

Year

Perc

ent o

f GD

P in

Hom

e C

ount

ry o

r Reg

ion

Japan

S. Korea+Taiwan

Table 1B. Outward FDI Flows from Japan and the NIEs (Percent of GDP) Regions 1993 1996 1999 2000 2001 2002 2003

Japan 0.3 0.5 0.5 0.7 0.9 0.8 0.7

S. Korea + Taiwan 0.7 1.0 1.2 1.5 1.0 0.9 0.4


34

Figure 2. Japanese Intermediate Goods Exports to East Asia

0

5000

10000

15000

20000

25000

30000

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Mill

ions

of U

.S. D

olla

rs

ChinaASEAN 4S. Korea + Taiwan

Table 2. Japanese Intermediate Goods Exports to East Asia (Billions of U.S. Dollars) Regions 1993 1996 1999 2000 2001 2002 2003 2004

China 6.2 9.2 10.1 12.1 12.6 15.6 21.1 25.7

ASEAN 4 12.0 20.0 14.3 18.4 15.5 15.8 17.3 19.7

S. Korea + Taiwan 14.5 19.5 16.3 20.1 15.0 16.6 19.3 22.9

Note: The data are defined in Appendix 2.

Source: CEPII-CHELEM Database

35

Figure 3. Exports from Japan to East Asia by Technological Intensity

Low-technology products (2.94%)

Med.-low-technology products (20.26%)

High-technology products (30.07%)

Medium-high-technology prod.(46.73%)


Note: Technological intensity is calculated based on the type of goods exported measured at the HS 6 digit level. For instance, 252 products at the HS 6 digit level are classified as high-tech. See Gaulier et al. (2005).

36

Figure 4. S. Korea and Taiwan's Intermediate Goods Exports to East Asia

0

5000

10000

15000

20000

25000

30000

35000

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Mill

ions

of U

.S. D

olla

rs

JapanChinaASEAN 4S. Korea and Taiwan

Table 3. S. Korea’s and Taiwan’s Intermediate Goods Exports to East Asia (Billions of U.S. Dollars) Regions 1993 1996 1999 2000 2001 2002 2003 2004

Japan 3.8 7.0 6.9 10.3 8.1 8.4 10.4 12.5

China 5.6 9.3 10.7 13.1 11.8 14.4 20.7 29.1

ASEAN 4 4.6 8.7 10.1 11.2 7.8 8.0 8.6 10.5

S. Korea + Taiwan 1.7 3.1 3.9 5.8 4.6 5.2 6.4 9.2



37

Figure 5. Exports from the NIEs to East Asia by Technological Intensity



Med.-high-technology prod.

(23.59%)

High-technology products (45.83%)



38

Figure 6. ASEAN 4's Intermediate Goods Exports to East Asia

0

2000

4000

6000

8000

10000

12000

14000

16000

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Mill

ions

of D

olla

rs

JapanChinaASEAN 4S. Korea + Taiwan

Table 4. ASEAN 4’s Intermediate Goods Exports to East Asia (Billions of U.S. Dollars) Regions 1993 1996 1999 2000 2001 2002 2003 2004

Japan 4.5 7.5 7.2 8.7 8.1 8.5 9.7 10.2

China 1.0 1.6 2.9 4.2 4.4 7.0 10.9 14.2

ASEAN 4 1.2 3.3 4.9 6.1 5.4 6.7 8.2 8.7

S. Korea + Taiwan 2.3 4.8 7.8 7.5 6.4 7.6 8.3 6.2



39

Figure 7. Exports from ASEAN to East Asia by Technological Intensity


Med.-high-technology products.

(21.64%)


High-technology products(38.55%)



40

Figure 8. Exports from ASEAN to China by Technological Intensity

Med-low-technology products (11.41%)


Med-high-technology prod.

(16.22%)




41

Figure 9. China's Intermediate Goods Exports to East Asia

0

1000

2000

3000

4000

5000

6000

7000

8000

9000

10000

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Mill

ions

of D

olla

rs

JapanASEAN 4S. Korea + Taiwan

Table 5. China’s Intermediate Goods Exports to East Asia (Billions of U.S. Dollars) Regions 1993 1996 1999 2000 2001 2002 2003 2004

Japan 1.1 2.4 2.9 4.0 4.3 4.9 6.3 8.7

ASEAN 4 0.7 1.2 1.6 2.0 2.2 2.9 3.8 5.3

S. Korea + Taiwan 0.8 1.9 2.5 3.3 3.2 4.2 5.2 7.3



42

Figure 10. Exports from China to East Asia by Technological Intensity


Med.-high-technology prod.

(19.97%)


Low-technology products(31.28%)



43

Figure 11. Intermediate Goods Imports of Individual East Asian Countries and Regions from East Asia as a Whole

0

10000

20000

30000

40000

50000

60000

70000

80000

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Mill

ions

of U

.S. D

olla

rs


Table 6. Intermediate Goods Imports of Individual East Asian Countries and Regions from East Asia as a Whole (Billions of U.S. Dollars) Regions 1993 1996 1999 2000 2001 2002 2003 2004

Japan 9.4 16.8 16.9 22.9 20.5 21.8 26.3 31.4

China 12.8 20.2 23.7 29.3 28.8 37.0 52.6 67.0

ASEAN 4 18.4 33.2 30.9 37.6 30.9 33.4 37.8 44.2

S. Korea + Taiwan 19.3 29.3 30.6 36.7 29.2 33.6 39.2 45.5



44

45

Table 7.

China’s Processing Trade – 1993 and 2005

Imports (%)

World S. Korea &

Taiwan Japan ASEAN 5 Hong Kong United States Europe Rest of World 1993 Total Imports 100 18 22 6 10 10 15 19 Normal Imports 37 2 8 3 1 5 8 9 Imports for Processing

35 11 8 2 7 2 2 3

Others 28 5 7 1 2 3 6 5 2005 Total Imports 100 23 15 11 2 7 11 31 Normal Imports 42 6 5 3 1 4 6 17 Imports for Processing 42 14 7 6 1 2 2 10 Others 16 3 3 2 0 2 2 4

Exports (%)

World S. Korea &

Taiwan Japan ASEAN 5 Hong Kong United States Europe Rest of World 1993 Total Exports 100 5 17 5 24 18 13 18 Normal Exports 47 2 10 4 10 6 7 9 Processed Exports 48 2 7 1 14 13 7 4 Others 5 0 0 0 0 0 0 5 2005 Total Exports 100 7 11 6 16 21 17 21 Normal Exports 41 3 4 3 3 7 7 13 Processed Exports 55 3 7 3 12 14 10 6 Others 4 0 0 0 1 1 0 2

46

Table 7 (continued).

China’s Processing Trade – 1993 and 2005

Balance of Trade (billions of US Dollars)

1993

World S. Korea &Taiwan Japan ASEAN 5 Hong Kong United States Europe Rest of World

Balance of trade -12.2 -14.0 -7.5 -1.3 11.60 6.3 -3.5 -3.8 Normal trade 5.2 0.3 0.7 -0.1 7.7 0 -2 -1.5 Processing trade 7.9 -9.5 -1.3 -0.6 5.7 9.7 4.2 -0.3 Others -25.2 -4.9 -6.9 -0.6 -1.7 -3.4 -5.8 -1.9 2005 Balance of trade 102.00 -99.84 -16.42 -23.81 112.25 114.27 61.37 -45.81 Normal trade 35.43 -12.91 -2.45 1.95 21.59 26.91 14.36 -14.01 Processing trade 142.46 -69.25 4.49 -13.31 85.05 92.94 60.42 -17.88 Others -75.88 -17.69 -18.46 -12.44 5.61 -5.58 -13.41 -13.91

Notes: Source: Gaulier, Lemoine, and Nal-Kesenci (2005), China’s Customs Statistics, and calculations by the authors. Europe includes Austria, Belgium, Denmark, Finland, France, Germany, Greece, Luxembourg, Netherlands, Italy, Portugal, Spain, and Sweden.

47

48

Figure 12. China's Imports for Processing by Country and Region

0

10000

20000

30000

40000

50000

60000

70000

80000

90000

100000

1992

1994

1996

1998

2000

2002

2004

Mill

ions

of D

olla

rs S. Korea + TaiwanJapanASEAN 5EuropeU.S.Hong Kong

Table 8. China’s Imports for Processing by Country and Region (Billions of U.S. Dollars) Regions 1992 1995 1998 2001 2002 2003 2004 2005

Japan 3.9 15.6 16.7 19.9 25.0 32.8 40.2 45.2

S. Korea + Taiwan 5.0 17.9 22.7 30.4 39.3 53.3 75.9 94.9

ASEAN5 1.3 4.2 6.7 10.4 14.9 22.6 30.0 37.4

U.S. 2.0 3.7 4.9 5.5 6.9 8.1 11.0 12.8

Europe 1.1 2.9 3.6 5.9 6.3 6.9 9.8 12.1

Hong Kong 16.6 6.3 5.2 6.6 8.0 7.7 7.8 7.7 Source: China Customs Statistics (2006)

49

Figure 13. China's Processed Exports by Country and Region

0

20000

40000

60000

80000

100000

120000

1992

1994

1996

1998

2000

2002

2004

Mill

ions

of D

olla

rs U.S.Hong KongEuropeJapanS. Korea + TaiwanASEAN 5

Table 9. China’s Processed Exports by Country and Region (Billions of U.S. Dollars) Regions 1992 1995 1998 2001 2002 2003 2004 2005

Japan 3.5 14.8 17.5 25.3 28.2 35.1 43.5 49.7

S. Korea + Taiwan 0.8 5.0 5.9 8.7 10.9 14.5 21.0 25.7

ASEAN5 0.9 3.4 5.1 8.0 10.2 12.8 18.4 24.1

U.S. 27.1 17.2 23.4 36.3 46.8 62.4 83.7 105.7

Europe 2.4 8.5 12.2 21.9 25.5 39.9 55.5 72.6


50

Figure 14. China's Trade Balance in Processed Goods by Country and Region

-80000

-60000

-40000

-20000

0

20000

40000

60000

80000

100000

120000

1992

1994

1996

1998

2000

2002

2004M

illio

ns o

f Dol

lars U.S.

Hong KongEuropeJapanASEAN 5S. Korea + Taiwan

Table 10. China’s Trade Balance in Processed Goods by Country and Region (Billions of U.S. Dollars) Regions 1992 1995 1998 2001 2002 2003 2004 2005

Japan -0.4 -0.7 0.9 5.3 3.1 2.4 3.3 4.5

S. Korea + Taiwan -4.2 -12.9 -16.8 -21.8 -28.4 -38.7 -54.9 -69.3

ASEAN5 -0.4 -0.8 -1.6 -2.4 -4.7 -9.9 -11.7 -13.3

U.S. -2 13.5 22.3 30.8 40.0 54.3 72.7 92.9

Europe 1.4 5.6 11.5 15.9 19.2 33.0 45.7 60.4


51

Figure 15. China's Value-Added in Processed Trade

0

5

10

15

20

25

30

35

40

1992 1994 1996 1998 2000 2002 2004

Per

cent

Series1

Note: Value-added is defined as the difference between the value pf China’s processed exports and the value of China’s imports for processing, divided by the value of China’s processed exports. Source: China Customs Statistics (2006)

52

Figure 17. Japan's Revealed Comparative Advantage

-30

-25

-20

-15

-10

-5

0

5

10

15

20

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

PrimaryBasic manufacturingIntermediate goodsEquipment goodsConsumption goods

Note: The data are constructed for individual products using shares of the overall trade balance rather than relative export structure as in Balassa (1965). Values for stages of production are then calculated by summing. See www.cepii.fr for a detailed description of how the data are constructed.

Source: CEPII-CHELEM database

53


Figure 18. The NIEs' Revealed Comparative Advantage

-120

-100

-80

-60

-40

-20

0

20

40

60

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004PrimaryBasic manufacturingIntermediate goodsEquipment goodsConsumption goods



54


Figure 19. ASEAN's Revealed Comparative Advantage

-50

-40

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-10

0

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50

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004




55


Figure 20. China's Revealed Comparative Advantage

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80

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004




56


Table 12. The Degree of Competition between Asian Countries’ Exports to the U.S. and China’s Exports to the U.S. in 2003* _______________________________________________________________ Japan 21.9% South Korea 40.9% Taiwan 68.8% Singapore 40.1% Indonesia 66.8% Malaysia 65.0% Philippines 60.7% Thailand 69.8% _______________________________________________________________ * A higher number indicates greater competition in individual product categories. Source: Updated from Kwan (2002).

57

Appendix 1. Studies Investigating Whether FDI Flows to China Have Crowded Out FDI Flows to Other Asian Countries20

1. Kamaky, Ahmed. 2003. “Behind the Surge of FDI to Developing Countries in the 1990s: An Emprical Investigation,” Working Paper of Department of Economics, American University of Cairo, Egypt. Kamaly (2003) adopted a fixed-effects formulation with a lagged dependent variable, which is ratio. More specifically, the model takes the form of: )/( GDPFDI

( )2,1 ,0~ uititititiit iiduuxyy σβδμα +′+++= −

In line with Arrelano and Bond (2003), a set of explanatory variables of the model has been used as instruments on the condition that ( ) tsuxE isit <= where,0 , for correcting the bias that would arise from usual OLS or fixed effects (within) estimator. Using the moment conditions involving the matrix of instruments, the paper obtained two variant of GMM estimators of the parameters δ andβ . The first estimation has been done in line with Arrelano-Bond two step GMM-IV estimators, while the second estimation was based on extended GMM-IV estimators, what the paper termed as GMM-SYS estimators. The second approach has the benefit of no need of first differencing, since GMM-SYS incorporates additional moment conditions by including additional instruments that are not correlated with the country fixed effects, iμ . The estimation results of the base regression (as reported in Table-6) show that the lagged dependent variable has statistically significant large coefficient of 0.73 exhibiting a high degree of inertia in FDI flows. The second largest coefficient is -0.041 for ‘bond yield in G7 countries’ as against 0.024 and 0.010 for ‘lagged real GDP growth rate’ and ‘openness’ variables respectively. A very high magnitude of lagged FDI/GDP combined with relatively small quantitative effects of the explanatory variables has been attributed to the persistence of FDI flows. The paper argued that the international interest rate has also been more important driving force behind FDI flows, as against country specific factors such as openness and economic growth. Overall, the past value of FDI largely determines the current level of FDI flows, probably explaining observed stability in FDI flows to some countries. Controlling for other regressors such as exchange rate variability (as a proxy for uncertainty), democracy, capital control and financial deepening, the study shows that GMM-SYS estimators are found more consistent compared to other competing estimators as derived OLS, between or within estimators or GMM_IV (Please see Table-8). 2. Mercereau, Benoit. 2005. “FDI Flows to Asia: Did the Dragon Crowd out the Tigers?” IMF Working Paper WP/05/189. Mercereau questioned use of log(FDI) as it assumes percentage change in FDI instead of the changes in the levels of FDI flows and thus not capturing the very notion of crowding 20 This Appendix was written by Mizanur Rahman.

58

out effects. The paper rather used FDI to China relative to total GDP of other countries of the region and also FDI to China relative to total FDI to the region and then estimated the impact of China on FDI flows to other countries by the flowing equation:

jtjtjtjtjt ChinaXfdifdi εμαβδ ++++= −1 , where is FDI to GDP ratio of country jtfdij at time t and is FDI flows to China scaled by either total GDP of the region or

total FDI flows to the region. The findings show that a 10 percent increase in China’s FDI market share (i.e., China’s FDI relative to total FDI to the region) appears to have lowered, on average, annual flows to other nations by about 0.4 percent of GDP. Given that China’s market share rose from an average of 26 percent in the pre-reform period (1984-91) to one of 56 percent in the post-reform period, 1992-2002, China’s negative impact on flows of FDI to other countries was around 1.3 percent a year on average. When the estimation is done with the interaction term , only two coefficients (Singapore and Myanmar) come out to be statistically significant. The paper argued that the role of overseas Chinese might explain the effect on Singapore, as the overseas Chinese account for a significant share of foreign investment in China. They invest in China because they have family connection or linguistic and cultural ties in the mainland China. Here the paper further argued that since Taiwanese investors channel their funds through Hong Kong and Singapore, a significant negative coefficient for Singapore while a statistically insignificant coefficient for Taiwan appear plausible. For Myanmar, the paper argued Singapore is the second largest investor to the country, while the traditional large suppliers such as the US and the EU stopped investing there. The study explained that a very restrictive investment and trading regime in Myanmar might divert Singapore’s FDI from Myanmar to China.

tChina

)_*( dummycountryChinat

However, it seems that FDI flows to countries are little correlated with their macroeconomic fundamentals, rather much to factors such as country’s strategic position in the international trade. For example, East Asian countries received stable flows of substantial share of FDIs, because these nations are the center of the gravity of international organization of production. They belong to a cross-border integrated production network where each country has its industrial organization in line with comparative advantage in international trade. If this is true, technological development and industrial upgrdation in those nations are endogenized by their dynamic position in the international production networks. Flows of FDIs are then an outcome of this integrated production relationship, much less due to their idiosyncratic macroeconomic policies and also factors such as GDP growth rate, exchange rate volatility, democracy etc. The existing literature (e.g., Kamaly, 2003) documented that FDI flow shows a pattern of long term inertia as the coefficient of lagged FDI/GDP ratio has outweighed cumulative magnitudes of other impacts by a multiple of four. 3. Eichengreen and Tong (2005) estimated gravity model in an instrumental variable (IV) regression framework to examine impact of Chinese FDI inflows on regional FDI inflows to Asia, Latin America, Central and Eastern Europe, and OECD countries. The findings show that Chinese FDI has a significant positive impact on FDI inflows to Asia,

59

but a significant negative impact on FDI flows to OECD countries. The paper also shows that there is little evidence on the impact of China’s FDI on other regions such as Latin America, and Central & Eastern Europe. The paper argues that in addition to relative costs of production, market-size considerations may have affected investors’ decisions to bring in FDI to China. However, the paper fails to address any issues surrounding the evidence of complimentary pattern FDIs in Asia. In further desegregation to examine impact of China’s FDI on other Asian countries, they included interaction terms of . They find significant positive coefficients for all Asian countries—coefficients for Japan and Singapore are largest in magnitude, while they are smallest for Korea, Pakistan and Bangladesh. The study explained Japan and Singapore are two major producers of capital goods and electronic components that are used in Chinese manufacturing and therefore are main originating countries of Chinese FDI. Though the study attributed smaller coefficients for Bangladesh and Pakistan to their weak link in the supply-chain of China, smaller coefficient for Korea has been labeled as a “hollowing out” effect of Korean domestic industry. This reasoning is likely to be misplaced as we see a very wider trading relationship between Korea and China, which has been along the line value-chain of international production organization in East Asia. If it is so, positive impact of Chinese FDI on all Asian countries may not be robust if time effect is properly accounted for. As Kalamly (2003) found that FDI flows exhibit a high degree of inertia to its observed pattern.

ttedChinaFDIficountry *i

60

Appendix 2. The definition of intermediate goods and parts and components. 1) CEPII Data _________________________________________________________________

CEPII Classification of Intermediate Goods (SITC Equivalents in Parentheses)

________________________________________________________________________ Intermediate Goods 1. Engines, Turbines and Pumps (See note 1) 2. Electric Components (See note 2) 3. Vehicle Components (Parts and accessories of motor vehicles) 4. Tubes & 1st stage processing products (Iron and steel wire, tubes, pipes, and pipe fitting) 5. Yarns and Fabrics (See note 3) 6. Wood Articles (Cork and wood manufactures, excluding furniture) 7. Paper and Pulp (Pulp, waste paper, paper, paperboard, Articles of paperboard or paper) 8. Metallic structure (Iron, steel, aluminum structures and

61

parts, metal containers for storage and transport) 9. Miscellaneous Hardware (See note 4 ) 10. Fertilizers (See note 5) 11. Paints (See note 6) 12. Plastics, Fibers and Synthetic resins (synthetic rubber, reclaimed rubber , waste of unhardened rubber, synthetic and man made fibers for spinning) 13. Rubber Articles (Rubber manufactures) Source: CEPII-CHELEM database Notes: 1.

• 741 - Heating and cooling equipment, and parts thereof, n.e.s. • 742 - Pumps for liquids, whether or not fitted with a measuring device; liquid elevators;

parts for such pumps and liquid elevators • 743 - Pumps (other than pumps for liquids), air or other gas compressors and fans;

ventilating or recycling hoods incorporating a fan, whether or not fitted with filters; centrifuges; filtering or purifying apparatus; parts thereof

• 71 - Power-generating machinery and equipment

2.

• 776 - Thermionic, cold cathode or photo-cathode valves and tubes (e.g., vacuum or vapour or gas-filled valves and tubes, mercury arc rectifying valves and tubes, cathode-ray tubes, television camera tubes); diodes, transistors and similar semiconductor devices; photosensitive semiconductor devices; light-emitting diodes; mounted piezoelectric crystals; electronic integrated circuits and microassemblies; parts thereof

62

http://unstats.un.org/unsd/cr/registry/regcs.asp?Cl=14&Lg=1&Co=741





3.

• 651 - Textile yarn • 652 - Cotton fabrics, woven (not including narrow or special fabrics) • 653 - Fabrics, woven, of man-made textile materials (not including narrow or special

fabrics) • 654 - Other textile fabrics, woven • 655 - Knitted or crocheted fabrics (including tubular knit fabrics, n.e.s., pile fabrics and

openwork fabrics), n.e.s. • 657 - Special yarns, special textile fabrics and related products

4.

• 693 - Wire products (excluding insulated electrical wiring) and fencing grills • 694 - Nails, screws, nuts, bolts, rivets and the like, of iron, steel, copper or aluminium • 695 - Tools for use in the hand or in machines • 696 - Cutlery • 697 - Household equipment of base metal, n.e.s. • 699 - Manufactures of base metal, n.e.s. • 746 - Ball- or roller bearings • 747 - Taps, cocks, valves and similar appliances for pipes, boiler shells, tanks, vats or the

like, including pressure-reducing valves and thermostatically controlled valves • 748 - Transmission shafts (including camshafts and crankshafts) and cranks; bearing

housings and plain shaft bearings; gears and gearing; ball screws; gearboxes and other speed changers (including torque converters); flywheels and pulleys (including pulley blocks); clutches and shaft couplings (including universal joints); articulated link chain; parts thereof

• 812 - Sanitary, plumbing and heating fixtures and fittings, n.e.s.

5.

• 591 - Insecticides, rodenticides, fungicides, herbicides, anti-sprouting products and plant-growth regulators, disinfectants and similar products, put up in forms or packings for retail sale or as preparations or articles (e.g., sulphur-treated bands, wicks and candles, and fly-papers)

• 56 - Fertilizers (other than those of group 272) 6.

• 598.1 - Wood- and resin-based chemical products • 598.3 - Artificial waxes and prepared waxes • 598.4 - Mixed alkylbenzenes and mixed alkylnaphthalenes, n.e.s. • 598.5 - Chemical elements doped for use in electronics, in the form of discs, wafers or

similar forms; chemical compounds doped for use in electronics • 598.6 - Organic chemical products, n.e.s. • 597.2 - Anti-knock preparations, oxidation inhibitors, gum inhibitors, viscosity improvers,

anti-corrosive preparations and other prepared additives for mineral oils (including gasoline) or for other liquids used for the same purposes as mineral oils

63



















http://unstats.un.org/unsd/cr/registry/regcs.asp?Cl=14&Lg=1&Co=598.1






• 53 - Dyeing, tanning and colouring materials

1) RIETI-TID Data Parts and Components are defined based on the Broad Economic Classification (BEC) of the United Nations. They include 1) parts and components of capital goods (BEC code 42) and parts and accessories of transport equipment (BEC code 521)

64


Appendix 3. Parts and Components Exports from East Asian Countries.

Figure 2A. Japanese Parts and Components Exports to East Asia

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rs

ChinaASEAN 4S. Korea + Taiwan

Table 2A. Japanese Parts and Components Exports to East Asia (Billions of U.S. Dollars)

Regions 1993 1996 1999 2000 2001 2002 2003

China 4.5 7.6 11.2 14.1 14.8 18.6 26.8

ASEAN 4 13.2 23.8 15.8 20.4 18.1 19.4 20.7

S. Korea + Taiwan 14.4 18.7 17.7 22.2 16.5 18.1 21.2


Source: RIETI-TID database.

65

Figure 4A. S. Korea and Taiwan's Parts and Components Exports to East Asia

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Table 4A. S. Korea’s and Taiwan’s Parts and Components Exports to East Asia (Billions of U.S. Dollars) Regions 1993 1996 1999 2000 2001 2002 2003

Japan 2.9 6.6 7.5 11.3 9.0 9.4 10.9

China 0.5 1.7 4.2 6.3 6.4 10.2 19.2

ASEAN 4 2.9 6.5 8.1 8.7 6.3 7.7 7.8

S. Korea + Taiwan 1.2 2.5 3.7 5.5 4.1 5.0 6.4



66

Figure 6A. ASEAN 4's Parts and Components Exports to East Asia

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JapanChinaASEAN 4S. Korea + Taiwan

Table 4A. ASEAN 4’s Parts and Components Exports to East Asia (Billions of U.S. Dollars) Regions 1993 1996 1999 2000 2001 2002 2003

Japan 1.9 4.4 6.4 9.2 7.9 7.5 8.9

China 0 0.6 2.5 4.9 6.3 9.4 14.8

ASEAN 4 1.3 4.2 5.5 7.6 6.5 8.9 9.8

S. Korea + Taiwan 1.3 3.7 6.8 10.4 8.7 8.8 9.0



67

Figure 9A. China's Parts and Components Exports to East Asia

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JapanASEAN 4S. Korea + Taiwan

Table 6A. China’s Parts and Components Exports to East Asia (Billions of U.S. Dollars) Regions 1993 1996 1999 2000 2001 2002 2003

Japan 0.7 2.7 4.1 5.8 6.5 7.6 9.6

ASEAN 4 0.2 1.2 1.7 2.2 2.7 4.0 5.7

S. Korea + Taiwan 0.2 1.6 2.6 3.8 4.0 5.3 7.2



68

Figure 10A. Parts and Components Imports of Individual East Asian Countries and Regions from East Asia as a Whole

0.00

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Table 6A. Parts and Components Imports of Individual East Asian Countries and Regions from East Asia as a Whole (Billions of U.S. Dollars) Regions 1993 1996 1999 2000 2001 2002 2003

Japan 5.4 13.8 18.1 26.2 23.3 24.5 29.4

China 5.0 9.9 17.9 25.3 27.4 38.2 60.8

ASEAN 4 17.5 35.4 31.0 38.9 33.5 40.0 44.0

S. Korea + Taiwan 17.0 26 30.8 41.8 33.3 37.2 43.8


Source: RIETI-TID database

69

70

NEAT Working Group Workshop on “Trade-FDI-Technology Linkages in East Asia”

7 July 2006, RIETI, Tokyo

The Name of Participants

Member <Brunei> Dr. Siew Yean Teo Economics Lecturer, Department of Economics, Faculty of Business,

Economics and Policy Studies, Universiti Brunei Darussalam <China> Dr. Liping HE Professor and Chair of Department of Finance at School of

Economics and Public Administration, Beijing Normal University <Indonesia> Dr. Ninasapti Triaswati The Indonesian Institute, Board of Advisor, responsible for advising

any economic issues associated with project carried out by the firm <Korea> Prof. Choong-Lyol Lee, Professor, Department of Economics, Korea University at

Suchang Campus <Laos> Mr. Sitthiroth RASPHONE Research Officer, National Economic Research Institute (NERI),

Committee for Planning and Investment (CPI) <Singapore> Prof. John Wong Research Director of the East Asian Institute (EAI) of the National

University of Singapore <Thailand> Dr. Chawin Leenabanchong Associate Professor, Faculty of Economics, Thammasat

University <Vietnam>

Mr. Nguyen Tien Phong Lecturer at the World Economic Faculty, Instittute for International Relations

<Cambodia> (absent) Mr. PUTH Hemonna Deputy Director ASEAN & Int’l Organization Department Ministry

of Commerce Phnom Penh <Malaysia, Myanmar and Philippines> Nobody was recommended by County Coordinators <Japan> Dr. Masaru Yoshitomi, President and Chief Research Officer, RIETI (Chairman) Dr. Willem H. THORBECKE, Senior Research Fellow, RIETI (Co-author with Dr.Yoshitomi)

71

Participants Prof. Akira KOTERA Professor of Graduate School of Arts and Sciences, University of

Tokyo /Faculty Fellow, RIETI Mr. Shigeaki SHIRAISHI Director, Policy Planning and Research Division, Trade Policy

Bureau, METI / Consulting Fellow, RIETI Prof. Shujiro URATA Professor of Graduate School of Asia-Pacific Studies, Waseda

University /Faculty Fellow, RIETI

Observers Mr. Kozo OIKAWA Chairman, RIETI Mr. Yasuo TANABE Vice-President, RIETI Mr. Yuji HOSOYA Director of Research Mr. Masahiko OZAKI Coordinator of Research, RIETI Dr. LIU Junsheng Visiting Scholar, RIETI

Amb. Naotoshi, SUGIUCHI Councilor, the Japan Forum on International Relations (JFIR)

Documents

Trade-FDI-Technology Linkages in East Asiaceac.jp/j/pdf/neat/04wg_7.pdf · capabilities, they can attempt to progress from original equipment manufacturing (OEM) to original design